Saturday, December 15, 2007

Why monetary policy easing is warranted even in the current insolvency crisis

Starting in 2001 the Fed cut rates from 6.5% all the way to 1% by 2003; in spite of that the bust of the tech bubble continued: the Nasdaq fell all the way from a level of 5000 to about 1200; other stock indexes in the US and abroad sharply fell; thousands of internet companies that were mostly “vaporware” – i.e. with little revenues, let alone earnings – went belly up and bankrupt. Thus that aggressive monetary easing did not succeed in bailing out investors.

Similarly today home prices that rose in a bubble like fashion by almost 100% in real terms between 1997 and 2006 will fall by at least 20% - if not more – regardless of what the Fed does; given the biggest glut in new and existing homes in US history and the biggest housing recession ever no amount of Fed easing will prevent this collapse in home prices. And the broader financial losses – that will be close to 1,000 billion dollars once you add sub-prime, near prime, prime, auto loans, credit cards, student loans, commercial real estate, leveraged loans and lending to the distressed parts of the corporate sector – will be massive regardless of what the Fed does. And once the unavoidable hard landing becomes clear to market participants the current delusional hope of the stock market investors that the Fed can prevent such hard landing will fizzle out and stock price will sharply fall as well. In a recession there is no room to hide: in a typical US recession – with or without Fed easing – the S&P 500 falls by an average of 28% in nominal terms and almost as much in real terms.

When bubbles go bust the Fed can only minimize the collateral damage to the economy and reduce modestly the severity of the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring as the experience with the S&L boom and bust in the late 1980s and the tech boom and bust in the late 1990s suggests.

Thus, the way to deal with the risk of new asset bubble is not to renounce monetary policy easing that is necessary to reduce the real economy collateral damage of a bursting bubble [i.e. depth & duration]; it is rather using the appropriate supervision and regulation of the financial system to ensure that a new bubble does not emerge from that monetary policy easing. It is still appropriate and legitimate use of monetary policy easing interest rates when an asset bubble bursts when both monetary and regulatory policies have been used to control a bubble when such a bubble is emerging; so a symmetric approach of monetary/regulatory policy [both up & down the cycle] to bubbles – rather than the asymmetric approach advocated by Bernanke/Greenspan/Kohn – is the appropriate way to minimize the risk of moral hazard and to avoid turning the Fed into a serial bubble blower.